CDO’s- The Garbage Dump Of Securitization

When CDO’s were first introduced I thought maybe I just did not understand. You take junk that nobody wants, dump it into a box, mix it all together and out comes AAA paper. Magic. When I was very active in the early stages of developing CMBS, we always knew there was an issue of what to do with the low level paper and how do you securitize loans that did not have any real cash flow. If this could be solved then the volumes and profits would increase substantially. CDO’s to the rescue. As one of my capital markets friends recently commented, the definition of a good banker is one who dreams up ways to get around whatever the latest rules and regs are.  

Despite the massive losses suffered by CDOs’ and their sponsors over the past two years, I hear that they may be making a come back. That would be terrible. A CDO is by design, an instrument of assured deception and destruction. If the loan was made to a solid cash flowing asset, and if there was true debt cover in stress scenarios, then the paper would be in a true CMBS pool. The only reason to have a CDO is to have a place to dump the risk and the junk, otherwise there is no need for it.

What always amazed me was the ability of the I banks to convince rating agencies that a large pool of garbage could be transformed into high quality paper and rerated based on the clearly false belief that not all of the pool will default and be bad and that by having a lot of different assets- diversity- the risk was changed into good cash flows. That is the ultimate –yes Virginia there really is a Santa Claus story.

Then we saw indexes of CDO’s, CDS issued against CDO’s, and a market that was pure fantasy having nothing at all to do with the quality of the cash flows of the underlying assets. It was designed to do what it did. Fool the rating agencies and the mass of institutional investors into believing what may have been the ultimate ponzi scheme.

While I never trust Congress to ever get it right, and while I am still a strong believer in the free market and freedom to innovate, Wall St cannot be trusted to behave responsibly. When I started in Wall St in 1965, it was a very different world. We had our excesses and scams, but the current generation of bankers is summed up by what a friend of mine in the business said to me recently.  “I want to get that consulting assignment from them so I can get inside and figure out how to rip their face off”.  The kids with the computers have no idea what the ramifications are of what they are doing. They are just trying to find another way to confuse the rating agencies and the buyers, and to make a bigger spread. If we are to avoid the next crisis, we need some way to prevent the return of CDO’s or their next iteration, and other financial products which have no true economic value enhancement purpose. I am not in favor of the government having this role. The financial instrument has got to be tied to the asset and cash flows emanating from that asset. The only real solution is to make bonuses deferred and tied to the product one sells, creates or trades, and to only pay based on three and five year outcomes. Only then will there be an economic incentive to act better and not just to maximize profit for the period to the year end bonus.  Your view changes completely if you have to be responsible in your wallet for your actions.